Liquidity Explained

Mar 20, 2018 | Team Ripple

The Financial Times defines liquidity within a transaction as how easy it is to perform an exchange in a particular security or instrument, or the ease of converting an instrument into cash for withdrawal. This takes into account the stability and price of each instrument over the course of a transaction.

If a financial transaction is an engine with moving parts and multiple factors that impact its performance, then liquidity is the oil that makes it move. Good, clean oil in the form of cheap and readily available liquidity means less risk and a faster, smoother transaction.

For routine domestic transactions like a debit card purchase or paper check deposit, liquidity is generally high because financial exchanges normally execute in a single currency and are approved against account balances held by each party in the transaction. But when you assess liquidity for international or cross-border transactions, the oil begins to thin and performance breaks down.

International transactions already face hurdles and delays because of country-specific regulations and currencies. Exchanging one currency for another introduces a price and time variance that could impact pricing on each side of the exchange. This erodes the stability of the transaction – therefore the liquidity – and increases risk and cost.

As a result, financial institutions must pre-fund nostro accounts on each side of a transaction in that country’s native currency. These account balances in a local currency improve liquidity by lowering the risk for the parties transacting.

The cost and complexity of holding these accounts around the world is one reason why only a handful of banks can process global transactions. The burden of maintaining nostro accounts worldwide is simply unsustainable for most organizations. Small-to-mid-size banks and payment providers instead pay a fee to use the international transaction systems of their larger brethren.

Digital assets can be used to lower the cost and improve the speed of liquidity for these cross-border transactions. This is especially true in emerging markets where the cost of currency exchange is high and the trading volume is low.

A digital asset designed for enterprise use can take the place of nostro accounts and offer on-demand liquidity. This is possible because the digital asset serves as a universal currency, instantly and cheaply changing any payment into its needed local currency.

This capability not only lowers the cost of the overall transaction, but it can speed up the exchange to real-time. In this way, the digital asset becomes the oil or the liquidity that drives transaction performance.

Banks and payment providers can then free up the assets that would normally be committed to funding nostro accounts around the world. Even better, banks and payment providers that would usually be locked out of transacting on their own, can now engage in international payments directly.

To be successful, a digital asset must be designed to settle transactions quickly. For example, Bitcoin (BTC) is a great store of value, but it is poorly suited for transactions because it can take over an hour to fully settle a transaction. It also has a limited capacity of 16 transactions per second (TPS).

By contrast, a digital asset like XRP settles in mere seconds and can handle 1,500 TPS – a throughput on par with Visa and other card networks. This is because XRP was created specifically for enterprise use to provide liquidity for international transactions.

Speed and volume are crucial considerations. The faster the transaction, the more a sender is protected from volatility risks and the faster the recipient receives fully settled funds. High throughput allows for a more stable volume of exchange for all market participants.